An obstacle to getting started with investing can be not having a structure to follow. Things become easier to follow when there are guidelines.
Since the world of investing spans such a great space and there are literally endless possibilities and results for your money, it helps to simplify the process with some constraints or rules. Here’s 4.
Financial Investing Rule #1: Get your financial priorities in order
This is the first and most important step for successful investing, and it has to do with your personal finances. The phrase “it makes money to make money” is ever so true in the investing world and has proven to be true over and over again.
Reliable returns from the stock market don’t involve a 10x return on your capital, which happens so infrequently. Rather, smaller average returns compounded over many years create reliable returns. But to make substantial money with these conditions, you need a high amount of starting capital.
So when it comes to your finances, you need to have them structured so you have a net profit each month. Spend less than you earn encapsulates this perfectly. Whether that’s through a budget or automatic withdrawals from your checking in month, I don’t really care. At the end of the day, you need to first have excess money to play with.
Once you’ve got the saving portion down, it’s time to look at other aspects. I’d say you at least need an emergency fund of $1,000 locked down. Some personal finance experts tout 3-6 months of expenses as an emergency fund, and I say if you want that then fine. For me, that’s too much and money goes too quickly to build that much when I have other places I want to invest my money. It’s really personal preference and risk profile.
The emergency fund is important because it keeps you from dipping into retirement accounts with steep penalties for doing so, or from accumulating high interest debt like credit cards once an emergency arises. Playing without an emergency fund and getting tacked on by these penalties that work like a negative compounding interest keeps you in a place where you’re going 1 step forward and 2 steps back. It doesn’t make sense.
Now let’s establish where to play your excess funds. First of all, I look for the things that will give me the highest return on my capital. Most of the time, this will be an employer match on a 401k. If the employer is matching you dollar for dollar, you are essentially getting a 100% return on your money. I don’t care what secret stock market trade you have under your belt, you aren’t getting 100% guaranteed returns anywhere else. Max out the match first and foremost.
Assuming you have no credit card debt, the next place to put yo money is in an IRA account. These accounts work as tax shelters and let you place investments inside them. These accounts also have contribution limits each year, so again max these out as much as you can.
Finally, you can put any remaining money you might still have into your 401k to get the tax advantages. If there’s any money after that, or you’d just generally prefer the taxable brokerage account, go that direction. The brokerage account is obviously nice because of the flexibility to buy individual stocks. Make sure you are definitely maxed out on the IRA accounts because those have the same flexibility of a brokerage account but without the tax implications.
Financial Investing Rule #2: You must fully understand the importance of long term investing
The reason why investing has become such a lucrative and important aspect of people’s lives is because of its results over the long term. The stock market is a generally volatile place and is not a great fit for the weak stomached casual investor, in theory. But even the most casual investor can make significant gains for himself if he understands this one rule.
Since the early 1900s the U.S. stock market as a whole has been increasing by an average of 7% each year. It’s had its ups and downs, bear and bull markets, but no matter how low or how high it has gotten… the market tends to revert to this 7% average yearly return mark.
The way to profit from this phenomenon is to buy and hold through the ups and downs. The longer you hold, the closer you’ll get to 7% annually. Let’s be clear, a 7% annual return is a great result for an investment. Combined with the power of compounding interest, 7% can grow your wealth steadily and briskly.
The trouble occurs when investors become emotional with their investments. They become greedy and try to exploit the timing of their investments by piling in more money near a market top. Or they panic near a market bottom and sell out their shares at a loss. Either result attempts to add an element of market timing to the investing process.
Market timing doesn’t follow the 7% annual return rule because it is so unpredictable. We can look up the facts behind how the market has done in the long term, but we can’t look up what the market is going to do in the next day, month, year or 5 years. It’s unknown and so the returns are unknown.
But the growth of the U.S. stock market is known, and it has survived through many depressions, recessions, and even major wars. Put the odds in your favor and cement a long term approach.
Financial Investing Rule #3: You absolutely need to diversify
Revisiting the previous rule helps us to understand why certain investing strategies work. In the previous example, the U.S. stock market grew as a whole an average 7% per year. The key emphasis in this is the “entire” stock market grew. Some stocks grew more, some stocks grew less… some stocks went bankrupt and some stocks lost significant share price. Without the ability to glance into the future, there is no way to pick out only the winning stocks and fend off the losers.
In the same token, there isn’t a stock picker out there who doesn’t get things wrong from time to time. So how do you confidently invest in a stock if any single one could wipe out a significant portion of your capital?
That’s where diversification comes in. You should ideally pick a portfolio of at least 15 – 20 stocks. This gives you a great chance at coming close to the 7% average without worrying about 1 or 2 bad picks ruining your financial future. In fact, with a portfolio like this you might even have a shot at earning returns greater than the average. If you prefer index funds, those are a great method of diversification as well.
But you must diversify, diversify, diversify. And not only with the number of stocks, but also in the sectors. As Jim Cramer likes to say, “there’s always a bull market somewhere” which means there’s also a bear market somewhere. Many sectors move independently from each other, and many of the stocks in a sector move the same way… up or down. So if you have a bunch of stocks from one sector in your portfolio, you aren’t really diversified.
But with positions from different sectors, you can absorb losses when one sector tanks. In the case that all sectors are tanking (i.e. bear market), diversification won’t help most of your positions from falling. That’s where the prudence of long term investing comes into play. Even in that case, a sector such as gold tends to rise when most everything else (even the sky) is falling. So try to maintain an equal level of diversification at all times.
Financial Investing Rule #4: If you want above average performance, you must put in the work
I’ll keep this last one short and sweet. If you want to beat 7% average returns, you have to mold yourself into a different kind of investor. The casual investor could take my first 3 rules and run with it, and be just fine financially. But for the investor that yearns for more, the journey is much harder and time intensive.
I do believe it can be done, however. Countless books have been written about beating the market. And most of the good cream has risen to the top. Books like The Intelligent Investor, What Works on Wall Street and Beating the Street are must reads to the enterprising investor who seeks above average performance. Those books are top classics for a reason and are packed with insightful and useful information.
It will take many hours of intense study and practical application to even have a chance of beating the market. There’s no guarantees, but reading this blog is a great start.